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. Last Updated: 07/27/2016

Reformed Rent-Seekers Promoting Reform?

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During the past five years, Russia's industrial labor productivity has risen by 38 percent, making the United States' productivity boom of about 13 percent appear lethargic in comparison. While some claim this growth was driven purely by devaluation and high oil prices, we believe this misses the point. In 1992, oil prices were high and Russia experienced a spectacular devaluation, yet its export sectors collapsed and the economy remained mired in stagflation until 1998. Something changed in the late 1990s.

In our view the crucial factor has been the emergence of a private sector with incentives to generate growth, following the mass redistribution of property during the initial voucher privatization and the loans-for-shares scheme of 1995-96.

In a survey of 64 of Russia's largest enterprises, we calculate that a single shareholder group has now established control over 97 percent of the privatized enterprises by revenues. On average, these core shareholders have 65 percent of a company's shares, giving them full effective control and allowing them to shift their focus to improving operations. And the turnaround has been dramatic.

In the early 1990s, when companies were still state-owned, there was little incentive to invest or generate growth. Instead, a feeding frenzy opened up as insiders and outsiders fought to gain control of cashflows, and the lack of ownership rights meant that the "winners" in these battles quickly transferred funds to jurisdictions abroad where property rights were protected and they could hold on to their winnings. Some far-sighted groups chose to collect shares despite the lack of effective property rights, and sometimes violent battles for control ensued. It is no surprise that as a result investment collapsed, capital flight soared, and even inherently profitable industries, such as oil, fell into rapid decline.

Today, there is a marked difference between the operational performance of companies where private shareholders have established control, and those under state ownership or where control is still dispersed. Among the country's 14 largest traded companies, we estimate productivity growth at state-owned companies has been 10 percent between 1998 and the present day, compared to 41 percent at private companies. This is perhaps the single clearest indicator that ownership has played a major role in the country's recovery.

Yukos has clearly led the way, with productivity up 100 percent since 1998, driven by applying new technologies and exploiting underutilized resources (i.e. better management). This contrasts with state-owned Gazprom where productivity remains flat -- despite a huge investment budget -- amid allegations of asset stripping and inefficient use of funds. Many other private companies, including Sibneft, TNK, Severstal and RusAl, are demonstrating how private owners can generate major productivity increases, while state-owned companies such as UES, Rosneft, Rostelecom and Tatneft are treading water.

However, the trend comes with a caveat. With the arrival of the new owners, there has also been a major concentration of ownership. In our sample of 64 companies, we estimate that 85 percent of privatized companies are now controlled by eight large shareholder groups, whose combined revenues in 2001 significantly exceeded total federal government revenues. The contrast is stark -- in 1992 this figure was zero.

This new class is cash-rich, politically powerful and likely to remain a strong lobby, giving it a powerful role in setting the course for Russia's future economic development. At times, the interests of this "big eight" have been closely tied to the nation's fortunes: They have successfully lobbied for radical tax reform, land privatization, state recognition of property rights and a realignment of foreign policy toward the West. It is in their interests to ensure a stable political regime and conservative financial policy.

However, history shows that such power can be abused. During the 1970s in Latin America, strong industrial groups promoted trade restrictions, choking off productivity growth -- just as Russia's automobile industry is currently lobbying for import tariffs to protect inefficient producers. In the 19th century, America's infamous robber barons monopolized key natural resources, and by artificially inflating prices slowed the development of the manufacturing sector.

Large enterprise groups in Japan continue to thwart competition by promoting excessive regulation, and in Korea inefficient investment led to an excessive build-up of debt, which is now being paid for by the households who lent their savings to the chaebol banks.

Given that Russian democracy has yet to mature and protection of smaller businesses and individuals is weak, the economic environment appears ripe for abuse by politically connected groups. However, despite these dangers, we are more sanguine in the longer term, and see three major causes for optimism about these new private owners.

First, Russia's major enterprise groups are largely focused around commodity exports, meaning that the risk of Latin American-style isolationism is minimal. On the contrary, these groups have an interest in promoting global economic integration. Over the next five to 10 years, we expect them to rapidly expand Russia's energy and commodity exports, giving them an interest in creating an economic environment where domestic and foreign partners are willing to make multibillion-dollar investments in the supporting export infrastructure. It is no coincidence that the country's largest oil producers strongly support better political ties with the G-7 and China, WTO accession and a free trade arrangement with Europe.

Second, Russia's large businesses are not the all-conquering machines that they are sometimes portrayed to be. Business is tough and many of the "oligarchs" of the early 1990s have already disappeared. Some groups have acquired assets with the explicit goal of restructuring and selling them. We expect this to lead to another wave of asset sales -- at much higher prices and with greater foreign participation -- weakening the role of the big eight in the economy. Also, as time passes the big eight are likely to face another problem. On the whole, they are owned by a small group of partners and have a nontransparent legal structure. We expect a gradual dissolution of these partnerships as the owners age and individual partners' interests diverge. Very few are likely to become family heirlooms.

Lastly, now is finally the time for Russia's small and medium-sized businesses to take off. Business has never been so profitable.

The reform agenda that was strongly supported by big business is paying off for small businesses too: Household incomes are rising quickly, taxes have been lowered, and the medium-term perspective finally looks stable. The problems for small businesses are also clear -- onerous regulation and interference by the authorities. While small businesses currently lack the power and mechanisms to defend their interests, and the jury is still out on how they will develop in the current environment, the smaller companies we cover all appear to have bright prospects.

If Russia's political leaders can help by reducing the hindrances to business development, in five years' time the small business sector could become a powerful political force. And that's one more reason to be sanguine about big business.

Peter Boone, head of research at Brunswick UBS Warburg, and Denis Rodionov, deputy head of research, contributed this comment to The Moscow Times. The views expressed are their own.